April 2009

April 12, 2009

On April 9, 2009 Eric Dash reported in The New York Times on the progress of the federal bank examiners' stress tests. The purpose of those tests is to determine how the nation’s biggest banks would hold up under simulated worst-case conditions. The good news is these banks are in better shape than many think, but:

… the tests, which are expected to be completed by the end of this month, are being conducted out of public view. Federal law prohibits the unauthorized disclosure of the results of any bank examination, including the stress tests. Some investors wonder if the new tests are rigorous enough, given the potential problems lurking inside the banking industry.

The bad news is the Treasury’s stress tests will be inconclusive and the results will not be made public. As an alternative I introduced the bank Asset Quality Index [AQI] in Which Banks Are Holding Those “Hard-to-Value” Assets? This index defines the probability that a bank is holding significant hard-to-value assets on its balance sheet. In that article I applied the AQI in a cross-sectional analysis of leading U.S. banks. This analysis operates on the normalized difference between each firm’s share of market value and share of total revenue in a group of eight banks covering the 36 quarters ending in 2008.

To the surprise of no one, it turned out that Citigroup (C) and Bank of America (BAC) respectively registered a 0.98 and 0.99 probability of holding hard-to-value assets. The probability that American Express (AXP) was holding some of these assets was 0.35, while Wells Fargo (WFC) and The Mellon Bank of New York (BK) both had less than a 1 in 100 chance of holding them. The purpose of this post is to show how the AQI tracks the surprisingly risky history of the three remaining banks: Goldman Sachs (GS), JP Morgan Chase & Company (JPM), and Morgan Stanley (MS).

THE ASSET QUALITY INDEXSince banks don’t sell products their revenues are dependent on fees for investment banking services and the interest they earn on performing assets. When investor’s price a bank’s stock they lean heavily on the quality of those assets. Unlike retailers (and manufacturers) that carry inventories and sell products, there is a more direct link between the quality of a bank’s assets and its market cap. I designed the AQI to capture the implications this link.

Technically, the AQI is a normally distributed variable with mean zero and standard deviation one. As a result, it may be interpreted as a probability by looking up any given AQI in the student t-distribution. The higher the AQI value, the less chance a bank has a significant proportion of hard-to-value assets in its portfolio. The lower the index the more likely the bank is to have a significant proportion of these assets in its portfolio.

GOLDMAN’S INCREASINGLY RISKY BETSThe following chart tracks the AQI of Goldman Sachs over the period from February 29, 2000 through November 30, 2008. The index numbers in red indicate increasingly higher probabilities that GS held hard-to-value assets in its portfolio from November 2002 through August 2007.

This chart documents almost five years of ever more risky bets by Goldman Sachs. Its AQI was -0.2 in November 2002 indicating a 0.58 probability the company was holding significant hard-to-value assets. By August 2007 Goldman’s AQI had declined to -3.9. In that quarter GS was virtually certain to be holding a damaging proportion of those pesky assets.

Apparently management then discovered their long run of risky bets and jumped into action. Within months GS cleaned its portfolio of those assets and reported an AQI of +1.6 in November 2008. By that time the probability that Goldman was holding such assets had plunged to 0.07.

MORGAN STANLEY’S INCREASINGLY RISKY BETSIn August 2000 Morgan Stanley’s AQI was +2.0, which indicated a probability of just 0.03 that is was holding hard-to-value assets. When in November of 2000 the AQI fell to -0.7 this set the stage for a long series of increasingly risky bets. The company’s AQI reached a low of -3.7 in February 2008. At that point MS was virtually certain to be holding a significant proportion of those assets on its balance sheet.

Like Goldman Sachs did earlier, Morgan Stanley management began to clean up the mess, reaching an Asset Quality Index of -0.9 by November 2008 indicating about a 50/50 chance it was still stuck with a bunch of those hard-to-value assets.

JP MORGAN’S EARLY CLEAN-UPMorgan management was ahead of the game in cleaning up its balance sheet. In September of 2002 JPM posted an AQI of -2.6, which at that time appeared to put its balance sheet much deeper in the toxic asset pool than either GS or MS.

Perhaps this motivated management to begin the early and systematic clean-up that reached a high point of +2.7 in September 2008 following its purchase of the Bear Stearns Companies (BSC) at a fire-sale price. The deal closed on June 30, 2008 and JPM’s balance sheet remained clean as a whistle after absorbing BSC. In September 2008 the probability it contained a significant proportion of hard-to-value assets was 0.0053.

In his Seeking Alpha article on March 17, 2009 Mark McQueen gave BSC a net value of -$4.3 billion. By the close of the 4th quarter 2008 the market apparently detected there were more of those hard to value assets in the BSC balance sheet than they had recognized – the AQI of the combined companies dropped to zero implying a 50/50 chance a significant proportion of those assets were still present.

THE VALUE OF THE AQIThe Asset Quality Index provides early warnings about the presence of hard-to-value assets on a bank’s balance sheet. It's a very handy way to sort the good from the bad and the in-betweens. It's also based on public data that can be updated every quarter. What do you think?

April 04, 2009

Everyone’s trying to figure out which banks are most likely to have hard-to-value assets on their balance sheets. I call these “hard-to-value” rather than “toxic” assets because what ever their value might turn out to be they’re not like a chemical dump.

New proposals appear every day. They range from setting up a “bad bank” to buy the assets, to running “stress tests” to see which banks would most likely fail/survive simulated worst case scenarios. One way to frame this problem is to assess the probability that any given bank holds a significant percent of hard-to-value assets in its portfolio.

In principle, there’s simple a way to calculate that probability. First, select a set of banks. There must be at least three in the set. Then track down two bits of published data: net earned income and market cap. Net earned income is a bank’s “revenue” -- what it earns from its performing assets. A bank’s market cap is, well, what investors think its worth.

Here’s how it works. Look up the revenue and market value of each bank for the last 36 quarters and calculate its market shares -- of value and revenue. Then subtract each bank’s share of revenue from its share of value and calculate the standard deviation of the differences over the 36 quarters. Finally, divide the differences by their standard deviation. The result is a standard normal variable (mean 0 and standard deviation of 1). Call it an Asset Quality Index [AQI]. This index has three very useful properties. It’s based on just two numbers that offer management very little wiggle-room. It’s easy to calculate. And, more important, it’s a probability.

The higher the AQI value, the less chance a bank has a significant proportion of hard-to-value assets in its portfolio. The lower the index the more likely the bank is to have them in its portfolio. This chart shows what eight of the countries biggest banks looked like in the 4th quarter of 2008:

Wells Fargo Company (WFC) is 6.5 standard deviates above the expected value of the AQI. Put another way: using the Student t-Distribution, the probability that WFC has significant hard-to-value assets in its portfolio is less than 0.00003. The Mellon Bank of New York (BK) with an AQI of 3.3 -- also is above the expectation. The probability that BK has a significant proportion of hard-to-value assets in its portfolio is 0.004. Apparently, there is nothing to worry about in either of these cases.

Goldman Sachs (GS) is in high positive territory pushing the 2 sigma limit. Even so, the chances loom larger. The probability that GS has a significant proportion of hard-to-value assets in its portfolio is 0.07. American Express (AXP) is even more problematical. With an AQI of 0.4, the probability AXP has some hard-to-value assets in its portfolio is 0.35. These probably are credit card assets.

Now things get much darker. The chance that J.P. Morgan (JPM) has a significant proportion of hard-to-value assets in its portfolio is 0.54. The chance that Morgan Stanley (MS) has some of these assets jumps to 0.81. As far as Citigroup (C) and Bank of America (BAC) go, look out below! The probabilities these two giants have significant hard-to-value assets in their portfolios are 0.98 and 0.99 respectively.

This is a handy, if unexpected, way to assess the probability that any bank has a significant proportion of hard-to-value assets in its portfolio. It might be a good idea to run this analysis on the financial institutions in your portfolio in order to pinpoint the risky ones in your neighborhood.

What do you think? As always your comments are welcome.

~V

Full Disclosure: I bought shares of Citigroup at a buck fifty and Morgan Stanley at six fifty -- for my grandchildren.